Category: NCUA

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A Pivotal Week for the Credit Union System’s Future

On Thursday, December 16, the NCUA board will meet to decide a slate of issues that will affect the credit union system for years to come, not just 2022.

The most consequential item is the proposal to approve and implement an entirely new RBC/CCULR capital regulation.

Tomorrow I will share one expert’s  analysis of the capital adequacy of credit unions since 2008.   All the numbers use NCUA and FDIC information.

The data, stress tests and bank comparisons demonstrate that credit unions created and maintained more than sufficient capital during the two most recent crisis, and the unprecedented growth in shares in 2020-2021.

The numbers are tested against actual data.  They clearly document credit union’s superior loan loss record versus banks.

The analysis poses the core issue: How does changing a tried, tested and proven system of capital sufficiency improve safety and soundness?   The rule provides no evidence that it would have in the past, or will in the future.

In fact the outcome is likely to be just the opposite.

If RBC/CCULR rule is implemented in any form, it will place a regulatory burden on credit unions that will be greater than any other rule ever passed.  Every credit union over $400 million (approaching the $500 million complex threshold) and above will have to maintain two different capital calculations under CCULR/RBC.  This occurs no matter which new standard a credit union  might wish to follow. For it will have to constantly monitor which is most advantageous for its circumstances.

Cross industry comparisons will become at best confused and at worst completely useless.   How do you compare a CCULR reporting credit union with one who has adopted the RBC approach with 8% net worth but a 19.5% RBC compliant ratio.

This new burden will fall directly on the members.   Members across the board will lose value for a rule that has no objective validation.

Budgets: Approving Spending Years into the Future

NCUA’s budget has a procedural flaw.  Estimates for the next year’s budgets are based on prior year’s budgets, not expenditures  or what was actually needed.  Therefore assumptions are carried forward, regardless of whether the circumstances justifying prior year’s requests  still exist.

For example one of the budget explanations  is a charge to the CLF as follows:

“total NCUA staffing includes five FTEs funded by the Central Liquidity Facility in 2022”

The CLF has not made a loan in over ten years.   Why should there be a need for any full time staff for an organization  that only manages a billion or more of credit union shares but has never developed a single program or made a loan to assist the credit union system for more than a decade?

Once a position is approved, it never goes away.

NCUA’s budget process is designed to justify spending rather than evaluate whether more resources are actually necessary to do the jobs at hand.

The major budget decisions include:

  • Increasing millions in additional spending charged to three funds plus capital spending;
  • Adding up to 48 new positions in addition to the seven approved at midyear;
  • Approving an allocation of NCUA overhead to the NCUSIF. Will it be based on the percentage of insured savings in state charters or some arbitrary number adjusted year to year without objective validation?
  • Setting the normal operating level (NOL) for the NCUSIF.

The question for the board is whether to direct staff to better manage the resources on hand or continue growing budgets unrelated to actual outcomes and efforts.

Each of these decisions will have significant impact in future years.   Will the NCUA board stop practices that are disconnected from actual facts and analysis, or will it just kick the can down the road?

Read the draft of the NCUA 2022-2023 budget here.

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A Better Way-NCUSIF Losses and Revenue Management

(Part 3 of 3 on the NCUSIF , A Better Way for credit union share insurance)

In 2010 GAO reviewed the FDIC’s financial statements for 2008 and 2009 (report 10-705). The summary, What GAO Found, contained the following comments:

“Because of a material weakness in internal control related to its process for estimating losses on loss-sharing agreements, in GAO’s opinion, FDIC did not have effective internal control over financial reporting  . . As of December 31 2009 the DIF had a negative fund balance of $20.9 billion and it had a negative 0.39 percent ratio of reserves to insured deposits.”

This was the third negative position for the fund since deregulation. In the most apocalyptic and highly erroneous NCUA projections about the corporate crisis during (and after) the Great Recession, none projected the NCUSIF would ever be in a deficit position.

After these two significant  economic downturns in one decade, the NCUSIF stands tall, stable and resilient.  However current NCUA Chairman Harper has openly called for the NCUSIF to be changed so it can mirror the FDIC-an entirely different financial design.

His suggestions show a  lack of knowledge about how the NCUSIF has succeeded in an environment that has seen every  other federal deposit insurance premium-based system fail.

NCUSIF’s Record in Recent Crisis

The 13-year period from 2008 through 2020 includes two serious economic downturns.

The cumulative insured loss rate for credit unions during this period is 1.5 basis points(bps) as shown below.  The annual losses range from 0 in 2020 to 6.96 bps when the taxi medallion losses were recorded in 2017.

The NCUSIF’s financial design rests upon the 1% deposit underwriting which grows proportionately with the insured risk plus an equity cushion that has had a traditional cap of .30 basis points of  insured shares.

The board is required to manage this equity level between .2 and .3.  If the NOL is under 1.2%, then the board must present a plan to return to this range.  Above the 1.3% cap (or other limit set by the board to a maximum of 1.5%), the board must pay a dividend to credit unions to reduce the equity to 1.3%.

Loss Provision Estimates Way off Mark

The fund has never incurred losses close to this 10 basis point range.   However NCUA’s loss estimates have often been spectacularly in error.   This graph shows that net cash losses reported in audits have no relation to provision expense.

The next chart shows how the much the overfunding of reserves  compares to actual losses.

The yearend loss reserve has fluctuated wildly  exceeding subsequent actual cash losses by over 10 times in multiple years (1,000%).

These wide disparities between actual losses and provision estimates require subsequent reserve adjustments.  These create very misleading financial bottom line results.  The provision expense, subtracted from or added back to earnings does not present  actual loss experience in a timely and consistent manner.

The fund’s structure is more than adequate for insured credit union losses.   What is most ominous is that NCUA seems to have no consistent, objective and verifiable method for setting the loss reserve.  That is a management problem, not a fund design issue.

When the  annual operating expenses of 1.8 basis points are added to the 1.5 basis points, total costs average 3.3 basis points.  As outlined earlier, the most persistent increasing expense is NCUA’s overhead transfer, not the costs from insured loses. This expense should be more controllable but has in fact become an increasing funding source covering almost two thirds of NCUA’s annual budget.

What About Revenue?

Costs are covered by revenue.  In addition to the two costs above,  income is required to maintain the retained earnings portion of the NOL growing at the same pace as share growth to keep a ratio in the .20-.30 equity range.

The math is easy.   An example. Assuming $1.5 trillion of insured shares, a cash loss rate of 1.5 basis points requires $225 million of income.   As investments equal 1.3% of insured savings, the an investments yield 1.2% covers losses.  To pay the 1.8 bps overhead expense adds another 1.4% for a 2.6% yield to cover all costs in the most 13 years.

If  the long term growth rate is 6.5% of insured savings, an additional yield of 1.3% is necessary to maintain equity. Using just the last decades results would seem to require a 3.9% yield to sustain the funds NOL.

But this return on investments is not required in most normal years.  And a far lower yield, as in the 2021 of 1.23%, can still result in a very strong bottom line.  Here’s why.

First, average insured losses at 1.5 bps are much higher than the long-term historical outcome.  The 13-year experience reflects two unusual events: the Great Recession of 2008-2009 and the taxi medallion losses.   If those three years removed from the average, the average insured losses are far below 1 basis point.

In 2021, insured share losses have been zero and there have been net recoveries from previous loss expense provisions.  In 2020, there were nil insured losses. In the previous three decades prior to 2009, insured losses were often zero and far under the most recent period’s 1.5 bps.

Overhead expense can be controlled.  It has grown at the same rate as insured shares (6.5%) because NCUA has transferred a disproportionate amount of its budget increase in every year to the NCUSIF—over 62%.  If the NCUSIF expenses grew at the same percentage as NCUA’s overall budget, this would reduce the 1.8 basis point portion significantly.  Moreover the growth in the investment portfolio shows that in 2021, the yield needed to cover this year’s projected $195 million OTR is only 1 bps.

Finally the equity ratio is a range of 1.2-1.3.   It can and has historically varied between a low of 1.24 to the cap set by the board in the past 13 years.  In other words a 1 to 2 basis point variance in yearend NOL is normal.  And if there is a truly unforeseen event, then the premium option can be exercised.

But the average model does provide guidance to the fund’s most important month to month role of managing the investment portfolio.   As described in prior posts, the NCUSIF investment committee seems oblivious to the current period of historically low interest rates.

As recently as August during the increased market worry about inflation and rising rates, the  investment committee acted by rote. It laddered out $1.2 billion (6.2% of the fund) at an average weighted  life and yield of 5.7 years and .943% .  One seven-year investment decision alone cost credit unions $42 million in lost revenue because of the committee’s timing.

This is not the first time the committee has made similar decisions seemingly oblivious of the historically low interest rate period the economy is passing through.

These kinds of investment decisions, the continual piling on of expenses, and significantly erroneous estimates of loss are all examples of inadequate management.  No fund design can overcome human folly.

A Dynamic Model to Follow performance

Even with a 1.22% yield in 2021, the financial reports through September suggest the fund will in fact have positive net income and grow the equity ratio.  Why?  There is minimal loss reserve expense and net recoveries from prior loss reserves, a lower cost  of operations, and a decline in insured share growth from 2020.

A simple spread sheet model can track all these variables in real time.  The spread sheet accessed here uses the September numbers for the NCUSIF and insured share growth.  It projects a year end equity ratio of 28.19 which with the yearend 1% deposit true up equals an NOL of 1.2819%.

So even in an historically low yielding and poorly managed investment portfolio, the fund’s result is within the designed outcome.

Even Better News

Traditionally the fund’s equity has not included the loss reserve which has been expensed from earnings but not used.   When this reserve is added to the yearend actual equity ratio, then the NCUSIF reserves are even stronger, always exceeding .30, sometimes by as much as 10-20 basis points higher.

The Better Way design works, not because it is perfect, but because it is flexible and aligns resources with insured risk through constant 1% deposit required from credit unions.  It tales prudent management of expenses, careful loss control and conscientious investment management.

To continue NCUSIF’s performance pattern, four steps should be taken:

  1. Audit and present the fund’s financial position following private GAAP accounting standards. Reset the NOL cap to 1.3% and follow accounting practice used prior to the 2001 change in recognizing the 1% deposit true up.
  2. Reduce the OTR to 50% to correspond to the percentage of state-insured shares in the fund.
  3. Update the oversight and transparency of the NCUSIF investments.
  4. Continue to minimize losses to the fund by working through problem cases not cashing out losses problems by sales to outside bidders.

 

 

 

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A Better Way IF Expenses Are Properly Managed

(Part 2 of 3 on  the  NCUSIF, A Better Way for credit union share insurance)

Throughout the NCUSIF redesign effort in 1984, credit unions had one primary concern with the new concept.  The question was, “If we send this money to Washington, how do we know government just won’t spend it?”

In response the legislation and implementation included multiple guardrails to prevent misuse of the fund by NCUA.  This included a legal cap of 1.3% on total fund size, after which a dividend must be paid; a limit on assessing premiums;  an annual independent  CPA audit following GAAP accounting; monthly public financial reports to the Board; the ability to withdraw the 1% deposit and a commitment to use the fund to minimize losses through 208 and other forms of temporary capital assistance.

Credit union concerns were well-founded.  The NCUA has become increasingly agile in charging the NCUSIF for its operating overhead expenses.

In the 13-year period 2008 through 2020, NCUA has spent a total of $3.321 bn.   Of that amount the operating fee has covered $1.172 or just 35% of NCUA’s expenditures. The NCUSIF has been charged $2.149 bn, or 65%.

Prior to the OTR change in 2001, the fund had never paid more than 50% of NCUA’s operations.

The Fund’s primary expense is for administration not insured losses

As a result, since 2008 NCUSIF’s operating costs exceeded the insurance loss provision expense of $1.880 billion by $270 million.  The primary financial role of the fund is to pay for insurance losses.  The cost have  been primarily through the Overhead Transfer Rate (OTR) process.  This process has been a source of ongoing  manipulation starting  in 2001.

The OTR History

Prior to 1985, the OTR was 33% which was based on the percentage of state-chartered insured shares in the NCUSIF.  In 1985 shortly after Ed Callahan left NCUA, the board raised the OTR to 50% even though the percentage of state chartered insured shares was still 33%.

This 50% ratio remained constant until 2001.  Dennis Dollar, as an NCUA board member and Chair (1997-2004),   made two changes in how the NCUA managed the NCUSIF. The first was making the OTR an annual adjustment, versus a fixed 50%  and secondly, delaying the recognition of the 1% deposit when calculating the yearend NOL.

The first change as reported in footnote 8 of the 2000 NCUSIF audit under the heading, Transactions with NCUA Operating Fund:

The allocation factor was 50% to the Fund and 50% to the NCUA Operating Fund for 2000 and 1999.  On November 16, 2000 the NCUA board voted to increase the allocation factor to the Fund for 2001 from 50% to 66.72%.

The only explanation for the change was that a new study of staff time spent on insurance versus supervision “indicated the rate should be changed to 66.72% for 2001.” ( Page 31 NCUA 2000 Annual Report)   This 33% increase in the transfer was at a time when state chartered  insured shares were only 44.6% of total NCUSIF insured risk.

Since this 2001 break with the long standing 50% transfer, the OTR has been recalculated every year reaching a peak of 73.1% in 2015.  The transfer rate for 2021 is 62.3 %.

The OTR has been the topic of contentious congressional hearings plus countless credit union objections to the arbitrary nature of the process.  See this link for congress’ questioning the OTR.  Even board members have expressed puzzlement with the explanations for how the transfer rate is determined.

Changing the NOL Calculation

The second change made in 2001 also had an ongoing consequence to the fund’s financial position and credit union’s dividend payment.

In 2000 the Normal Operating Level (NOL) was calculated as follows in footnote 5, Fund Capitalization:

The NCUA Board had determined the normal operating level to 1.33% as of December 31,2000, which considers an estimated $31.9 million in deposit adjustments to be billed to insured credit unions in 2001 based upon total insured shares s of December 31,2000. . . The CUMAA mandates the use of year-end reports of insured shares in the calculation of specified ratios and thus dividends related to 2000 will be declared and paid in 2001 based on insured shares as of December 31, 2000, as reported by the insured credit unions.

This was the method used in all the fund’s preceding years. Subsequently dividends of $99.5 million associated with insured shares as of December 31, 2000 were declared and paid in 2001.

But then this NOL calculation,  a consistent process  since 1985, was changed by the Board in 2001 as explained on page 21 if the Annual Report:

the deposit adjustment credit unions submit to the Share Insurance Fund to maintain their required deposit level of 1 percent of insured shares is not recorded until March 2002. In March, the equity ratio moved above the normal 1.3 percent operating level established by the Board. 

This delayed recognition allowed the NCUA to omit the required dividend in 2001 because the actual ratio exceeding 1.3% was not recognized until March.

Since the redesign of the NCUSIF’s in 1984, the adjustment to the 1% deposit had always been collected after yearend (as is the case today), but  still recognized in full when calculating the  December 31 NOL.

This change was discussed in the audited footnote 5 which revised the previous 2000 NOL calculation as follows:

The equity ratio at December 31, 2000, was 1.33%, which considered an estimated $31.9 million in deposit adjustments billed to insured credit unions in 2001 based upon total insured shares as of December 31, 2000. Subsequently, such deposit adjustments were excluded and the calculated equity ratio at December 31, 2000 was revised to 1.30%.

Thus the NCUA board gave itself the flexibility to delay recording the 1% true up versus continuing an  established and clearly understood ratio computation followed for almost 20 years in NCUSIF’s audited statements.

The Impact on the NCUSIF Financial Reports

The annual change in OTR from the long standing 50% and the delayed recognition of the 1% true up have given NCUA greater access to NCUSIF funding.

Since 2008, the operating expenses allocated to the NCUSIF have grown at an annual rate of 6.9%.   In contrast, following the change to a “variable” OTR, the operating fees paid by federal credit unions have increased only 3.6% demonstrating NCUA’s  increased use of the NCUSIF for its total budget.

The graph below shows NCUSIF operating expenses are almost all due to the Overhead Transfer with a different rate set each year.

Regaining Accountability for the NCUSIF

Credit unions were prudent to worry about NCUA’s instinct to spend money under its stewardship.  The NCUSIF is meant to be a financial safety net for the cooperative system. Instead it has been converted to a cash cow  anytime NCUA wants to reach in for more money via the allocation process.

Dividends that would have been paid under the 35- year long-standing 1.3% NOL cap were eliminated when  NCUA simply raised the cap to 1.39 in 2017 and 1.38 in subsequent years.  As many commentators pointed out, there was no objective  data supporting this change.

NCUA’s annual open-ended expense draw compromises the Fund’s primary role as a resource for insurance losses. Before the OTR change in 2001, the NCSIF paid six consecutive dividends. This kept NCUA’s commitment that credit unions could earn a dividend on their 1% investment in years of negligible losses.

Now NCUA takes their toll off the top rather than being limited to 50% a number which aligns with the proportion of state-chartered NCUSIF insured shares.

It is the NCUA board that made the above changes.  Accounting standards can accommodate different ways of presenting financial information.  These statements reflect management decisions, not accounting truths.  The changes in practice described about were not  in the best interests of credit union owners.  Auditors present, but do not approve such decisions.

NCUA’s 2022 budget is up for debate and comment.  The OTR should be set to reflect the proportion of state insured shares, not some opaque, manipulated internal study.  Expense control is a critical for  the proper management of any organization but especially a fund set up primarily to pay for insured losses.

Credit unions  have a duty to  speak up so the Board can right this series of decisions shortchanging the fund’s owners today.

Tomorrow in part 3 I will review the history of NCUSIF losses  to  analyze whether the long standing 1.3% cap and 1% deposit design provide sufficient financial resources for the fund.

 

 

 

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The NCUSIF is A Better Way– IF Properly Managed

The NCUSIF’s redesign culminating in the October 1984 NCUA board implementation was revolutionary.   This two-minute excerpt is from NCUA’s Video Network of that historical vote:

NCUA Bd Mtg Approves NCUSIF Redesign: A Better Way .

A Partnership

Board member PA Mack summarizes his approval saying:   I’m ready to support this and think it is an outstanding product as a partnership among government and credit unions.”

NCUA wanted credit unions as partners, with mutual give and take, and together the cooperative system created the most successful federal insurance program ever. 

Can Work Beautifully

When approved by a 3-0 vote, Chairman Ed Callahan congratulated everyone for their efforts and commented:  “This is a very significant thing for credit unions.  This system can work beautifully for credit unions in the future. I think the real challenge goes to you people in NCUA now.  The real secret is in the operations.” 

Callahan believed the power of NCSIF’s redesign was that it clearly invites credit unions into “cooperation” now and as long as the system’s integrity is preserved though proper management.

A Three-Year Process

This redesign did not happen overnight.  It emerged due to the failure of the premium based approach modeled after the FDIC and FSLIC funds founded four decades earlier.  This reassessment was documented in a 120 page report NCUA sent to Congress in April 1983. It featured  comments from all segments of the credit union system. Legislation was drafted with credit unions and sent to Congress in 1984.

NCUA actively encouraged credit unions to support the legislative change.  An NCUA video outlined the plan including the NCUSIF’s financial history since 1971-1984.  This analysis was the foundation for creating A Better Way.

In the 1985, NCUA reported the outcome for credit unions following the first year of this new design:

Dividend of 5%: Because of the fund’s performance . . . for the first time ever the NCUSIF paid a dividend which represents about $30 million in equity distribution. . . The NCUSIF has returned in some form almost $270 million to credit unions: the $84 million equity distribution (when calculating the 1% deposit), the insurance premium waiver for last year, the $30 million dividend and leading into the next year, a $90 million premium waiver.  (Source:  Page 5 NCUSIF 1985 Annual Report)

The partnership approach based on transparent communication with credit unions and immediate return created another system benefit. The radical restructuring proved to be the way to something more– an action  that renewed the entire system’s hope during deregulation and that credit unions still benefit from  today.

The Operations of the Fund

The critical aspect of the NCUSIF’s cooperative design, as noted by Chairman Callahan, is how he fund is managed by NCUA staff.  These four primary responsibilities include:

  • The regular, timely and accurate reporting of the fund’s financial position.
  • Prudent oversight of  NCUA’s operating expenses charged to the fund.
  • The careful management of fund losses to ensure the least possible cost resolution for problems.
  • Intelligent and professional management of the fund’s primary revenue source- the yield on its investment portfolio.

In the aftermath of the 2008-2009 financial crisis a material change occurred in NCUA’s management of each of these responsibilities—all contributing to an increasingly confusing and misleading presentation of the fund’s financial status.

Today I will focus on the 2010 change from private GAAP accounting to Federal GAAP. Future posts will discuss the remaining three responsibilities.

The Ill-suited Change to Federal GAAP Presentation

From 1982 through 2009, the NCUSIF financials were audited and presented following private GAAP accounting standards.  This was a critical part of the NCUA commitment to follow the same reporting and presentation standards it required credit unions to implement.

Credit unions had agreed to the perpetual 1% underwriting of their NCUSIF deposit. In return the NCUA guaranteed the information to properly monitor the agency’s management of these ever- growing 1% deposit assets.

This private accounting standards in 1982 was a departure from the NCUA’s initial practice of relying on a GAO audit which was often late in completion and did not follow GAAP accounting practices.

Why Reliance on Federal GAAP is Inappropriate and Misleads Credit Union Owners and the General Public.

Federal GAAP reporting was intended for use by entities that receive appropriations from the government.   The NCUSIF receives no government funding.  The  unique cooperatively designed fund relies on withdraw-able member deposits as the principal underwriting  source, not an insurance premium expense levied on credit unions.

In Federal presentation the normal balance sheet categories are divided into Intra-governmental accounts and Public accounts, a confusing description at best.  Liabilities have the same misleading divisions.  The Net Position contains a federally  defined Cumulative Results of Operations, sometimes mischaracterized  as retained earnings.  However in federal GAAP this account includes changes in the net unrealized gains and losses on the NCUSIF’s investment portfolio during the year.

Private GAAP does not include this.  As a result the monthly income and yearly audited statements present a completely misleading number from a retained earnings or equity perspective.

The traditional income and expense information is  renamed as Statement of Net Cost.” This presentation is similarly as confusing and misleading as the balance sheet categories. The presentation begins with Gross Costs , followed by Less Exchange Revenues, with a so called bottom line labelled,  Net Cost of Operations.

In 2020, Federal GAAP reported an NCUSIF  bottom line of a $239 million gain; however private GAAP net income was only $32.9 million.  The outcome is that actual retained earnings do not correspond to cumulative results of operations, thus misstating the true NOL when the 1% deposits are added. This annual over or under presentation of “fund equity ” is shown in the following chart.

Federal government accounting  reporting does not appropriately present the fund’s “equity” at yearend

This confusing presentation continues in the other required financial statements. These include the federally prescribed Changes in Net Position and the Statements of Budgetary Resources.   Neither portrays the data needed to understand traditional financial concepts of changes in cash flows, retained earnings or total equity.  These concepts were created for federally appropriated entities.

To see the full 2020 audit report following Federal GAAP presentation, click here.  Pages 13 and 14 are completely unintelligible versus private GAAP presentation.

The standard Federal GAAP presentation is so confusing that when staff updates the NCUSIF financial results to the board, the income statement and balance sheet are converted  to the standard GAAP income and balance sheet formats.

However even this monthly “translated” accounting practice is a mash up of private and federal GAAP concepts.  For example the most recent NCUSIF update showed  a quarterly net income at September 30 of $58.6 million.  The balance sheet account which would include this gain is called the Cumulative Results of Operations.  That account instead shows a quarterly  “loss” for the September quarter of $16 million.   This $75 million total difference is due to the net decline in market valuation of the investment portfolio.

Two Different NOL Calculations in the Audit

These distortions continue even when NCUA calculates the formal audited NOL ratio at yearend.  In the 2020 audit footnote 13  states the NOL is 1.26%.  This number is calculated by dividing the total Net Position of $18.9 billion by yearend insured shares of $1.5 trillion.

However in the same audited statement NCUA presents a different way to calculate the NOL and whether a dividend is due credit unions:

The NCUSIF equity ratio is calculated as the ratio of contributed capital plus cumulative results of operations, excluding the net cumulative unrealized gains and losses on investments, to the aggregate amount of the insured shares of all insured credit unions.  (pg 134 NCUA annual audit for NCUSIF, emphasis added)

Subtracting the net gain of $511 million NCUSIF net investments  at 12/20 from cumulative results of operations gives and NOL, per the above paragraph,  of 1.228 or 1.23%.   Which number are credit unions to believe?  Which NOL calculation determines the dividend?

Why Readopting Private GAAP is Critical

The confusions and misleading calculations shown above are just some of deviations from private GAAP accounting financial presentation and audit scope.

Moreover the misrepresentation even extends to how the 1% required credit union deposit true-up is included in the yearend NOL calculation.

The recognition of the 1% required capital true up was a settled financial practice until the board chose to change this in 2001.  Today that change continues to distort the true NOL.

For example the traditional method for NOL calculation followed from 1984 through 2000 would result in an NOL of 1.32% at 2020 yearend. ( a retained earnings ratio of .32 plus 1%) This is much higher than either of NCUA’s two reported calculation methods in the NCUSIF audit.

This underreporting misrepresents the NCUSIF’s actual financial strength and would deny credit unions a dividend if the historical NOL cap of 1.3% had been in place.

For users of the NCUSIF financial statements, Federal GAAP is confusing and misleading.  The NCUA in fact continues to use private GAAP in all three of its other fund annual audits and monthly presentations.

“Fairly presenting” the NCUSIF results for credit unions requires a return to an accounting system which credit unions can understand so they  can monitor their investment in the fund.

Tomorrow I will look at how NCUA has changed the way it charges the NCUSIF for its operating expenses.  And the consequences on the fund’s financial performance.

 

 

 

 

 

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NCUA Board Sets Critical Precedent and An Important Oversight Role for Itself

The process took 23 months.   The appeal required multiple in-person meetings. And oral hearings.  The credit union engaged an attorney. The most senior regional and professional staff at NCUA opposed the petitioner’s request.

In the end, the board exercised common sense.  It adjudicated the appeal in favor of the credit union.  A difference  that, on the record, should have been resolved at agency’s local level.

This event is the first time in a long, long while in which the NCUA board has acted as a true board.   It overturned the actions and judgment of agency senior staff in their most important activity-examinations.   This decision could be a critical turning point in board oversight and staff accountability.

This summary is prepared from the Order published by the agency.

Background Summary

On November 26, the NCUA released a Decision and Order on Appeal of a Region’s and Supervisory Review Committee’s  CAMEL 3 examination rating of a credit union.

The Order provides  dates for the many steps required in this elongated bureaucratic appeal process.  The Order repeatedly presents the explanations for the Regional office’s downgrading  of the examiner’s recommended CAMEL 2 rating to CAMEL 3, and the SRC’s concurrence.

The examination date was December 2019.  The Board released its Order in late November 2021, or almost two years after the exam date.

Reading the agency’s repeated justifications for not correcting a flawed process reminds one of the old joke about NCUA examinations:

Question: What’s the difference between your NCUA examiner and a terrorist?

Answer: You can negotiate with a terrorist!

The Board’s Finding and Conclusion on the Credit Union’s Appeal

 

The Finding by the Board

After a de novo review of the administrative record, and taking both parties’ oral presentations under advisement, the Board finds, by a two to one vote, that the Region erred in assigning Petitioner a composite CAMEL 3 rating, effective December 31, 2019.

The Board notes the record in this case reflects several documented errors on the part of the Region, including miscommunications and breaches of NCUA examination procedures. Notably, the credit union was given an exam report containing composite CAMEL 2 language to support a composite CAMEL 3 rating. In addition, the exam report included DORs that did not cite a specific regulation, in violation of agency policy and regulation.25 Accordingly, the Board considers those DORs26 invalid and they are accorded no weight in this appeal.

Looking purely at the numbers, Petitioner’s ratios appear to be better than, or in line with, the average lowest rated composite CAMEL 2 credit unions:

The Board disagrees with the Region’s Asset Quality rating. The solid performance of Petitioner’s loan portfolio infers that the Region’s rating was based on the quality of the borrowers, rather than the quality of the loans. For example, although the borrowers’ average FICO scores were in the low 600s, delinquencies are very low. The Board notes it is much easier to achieve low delinquencies with borrowers with higher (e.g., 750 – 800) FICO scores.

Further, while the Board is not prepared to overturn the Region’s Capital rating, the Board is concerned that the Region failed to articulate to Petitioner why this credit union’s risk profile demands such high capital levels, especially when capital adequacy is defined by the Federal Credit Union Act (FCU Act).27 Petitioner’s net worth position of XXXX percent is considered well capitalized under prompt corrective action.28 The Board notes XXXX Petitioner’s net worth was still stronger than statutorily required by the FCU Act.

Additionally, the Board disagrees with the Region’s Management rating. XXXX Management understands how best to work with the credit union’s members XXXX.

Conclusion

The Board finds nothing in the record to support this credit union is “less capable of withstanding business fluctuations and [is] more vulnerable to outside influences.”29 Based on the Board’s full and independent review on appeal, the Board finds the Petitioner’s composite CAMEL 3 rating is not justified. Instead, a composite CAMEL 2 rating is appropriate.

Why This Example Is Extremely Important

The agency process for this extended appeal  lacked any semblance of mutual objectivity. Following are the timelines of the exam and appeal process presented in the Order:

Examination data used:  December 31, 2019

Exam began: February 29, 2020

Report released by Region: June 25, 2020 (six months after the exam date)

Credit Union Board met with Regional staff: July 14 2020

Credit union filed request for reconsideration: August 13, 2020

Region reaffirmed the CAMEL 3: September 11, 2020

Credit union letter to appeal Region’s Decision to the SRC: October 8, 2020

Appeal letter opened by SRC 42 days later: November 19, 2020

SRC held oral hearing with credit union: February 2, 2021

SRC affirmed the Region’s CAMEL 3: March 2, 2021

Credit union filed supplemental appeal letter to NCUA: April 14, 2021

Credit union requested an administrative review by NCUA board: granted April 20,2021

NCUA Board oral hearing with credit union: June 10, 2021

Order issued  assigning a CAMEL 2: September 8th, 2021 (last modified date of November 22, 2021)

For any credit union to persevere during this nearly 23 month gauntlet of appeals and hearings in the face of bureaucratic intransigence is a demonstration of true grit and determination—even courage.

The fact that the Board was willing to listen to the appeal and then reverse the agency’s repeated justifications of its actions, is a noteworthy and critical exercise of Board oversight.  For the Board  directly challenged and changed the Region’s and SCR reasons for assigning specific CAMEL ratings.

Why was the credit union so persistent?  Especially as the standard for appeal to the board is difficult: “the burden of showing an error in a material supervisory determination rests solely with the insured credit union.11”

This criteria means the credit union must show that the agency made a mistake.   Such a finding is contrary to every regulatory impulse that the regional office’s judgments and findings can be incorrect.  It shatters the aura of expertise that is the core of a regulator’s authority.

What the Supervisory and District Examiners Told the Credit Union

The following is from the oral recordings and written transcripts of what the Supervisor and District Examiners told the credit union in assigning a CAMEL 2 rating upon completing the exam:

The Composite CAMEL rating is based on our assessment that you are fundamentally sound. For a credit union to receive this rating, generally no component rating should be more severe than a 3. Only moderate weaknesses are present and are well within the board of directors’ and management’s capabilities and willingness to correct.

While this rating results in an upgrade, as you do not pose material concerns, we have retained a management rating of “3.” This rating indicates some degree of supervisory concern. You will not qualify for an extended exam program and will remain on a 12-month examination supervision schedule.

Bureaucratic Jargon Overrides: “Authorized and Unauthorized Examination Versions”

NCUA Regional staff explained this overruling of the district and supervisory examiner’s CAMEL 2 rating by saying it was an “unauthorized version, erroneously issued.”

The Region’s “authorized exam version” explanation is that upon its review, “the Region found that staff had mistakenly excluded from the examination report closing language that had been approved for release. Noting that the reconsideration determination should be considered an addendum to the examination report, the Region’s September 11 letter indicated that the final paragraph in the Examination Overview that discussed Petitioner’s composite CAMEL 3 rating should have read:        The Composite CAMEL rating is 3”

 “Arbitrary and Capricious”

This overturning of the field examiners’ judgment was the core of the credit union’s appeal.

Petitioner further contends that the Region’s field examiners followed NCUA’s published examination procedure by including their first-hand observations and on-site assessments of the credit union into a draft examination report that concluded a composite CAMEL 2 rating was appropriate, but that same draft examination report was subsequently altered after field staff was “overruled,” to reflect the final composite CAMEL 3 rating that was issued to the credit union. Petitioner argues that “the same set of facts resulting in two different and inconsistent conclusions is by definition arbitrary and capricious and fundamentally lacks a rational and reasoned connection to the evidence.” 

A Credit Union to Be Saluted

We do not know who the credit union is. It takes a special kind of leadership  to challenge regulatory authority when a credit union has been wronged. The process takes time, resources and distracts from the primary job of serving members.  The emotional toll can be telling as well.

Every credit union knows the examiners will be back in another 12 months and the agency is always tempted to prove they were right.   The fact that the board was willing to take this appeal and support the credit union’s position is an important check and balance that has been long absent in NCUA examination and supervisory actions.

A Worrisome Dissent

The dissent by chairman Harper presents interesting logic.  He writes:  “Although the process by which the credit union received its report and rating was inconsistent and flawed,31 an inconsistent and flawed process can still produce a reasonable and supportable result.”

An NCUA chairman seeing an “inconsistent and flawed process” should have set off alarm bells about the agency’s entire examination effort, not to mention the internal review process.

Moreover, if the means to an end are found deficient, how does one justify the end result or, in this case CAMEL assignment? That is the arbitrary moment that many credit unions have experienced in examinations.

For data and logic are the way sound judgments are supported.   This is a critical skill for examiner effectiveness in their credit union dialogues.   It should be modeled at the highest levels in the Agency, not asserted using one’s position of presumed authority.

Following are two additional references from the Order presenting the distinction between regulations and guidance,  which were used by Board:

25 NCUA’s regulations, Part 791, Subpart B, reiterates the distinctions between regulations and guidance and prohibits examiners from criticizing (through the issuance of DORs and supervisory recommendations) a supervised credit union for a “violation” of, or “non-compliance” with, supervisory guidance. The NCUA’s National Supervision Policy Manual requires examiners to cite to the specific section of the Federal Credit Union Act, NCUA regulations, Federal Credit Union Bylaws, or other authority and (if the credit union violates more than one) to cite the highest authority.

26 Of the DORs included in Petitioner’s exam report, 2 of 5 DORs included specific regulatory citations, while 3 of 5 included only general or incomplete citations.

 

 

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GAO’s NCUSIF Study Omits the Most Important Data Point

The GAO  released a report in October analyzing the causes of credit union failures from 2010-2020.   The news stories and report lead with two facts:  145 credit unions caused $1.55 billion in losses to the NCUSIF in these eleven years.

The full report  took 16 months to complete and contains appendices full  of math correlations and sophisticated looking analysis.

However it omits the most important fact about these losses.  That is the NCUSIF’s 1.30 Normal Operating Level (NOL) is 93 times larger than the rate of insured losses for this period.  That is a critical actuarial finding.

The GAO failed to put its analysis in any context or perspective.  Any loss is too much.  All credit unions operate in a competitive market.  As noted by Ed Callahan when Chair of NCUA discussing deregulation, “Some credit unions will do better than others.”

The most important issue is the financial impact of losses on the NCUSIF and credit unions.   Using the GAO’s $1.55 bn total, this results in a loss rate on insured savings in this eleven-year period of 1.4 basis points.

The loss  trend is also declining as noted in the study.  Of this total, the report (page 13) says $831.7 million was from the failure of three taxi medallion credit unions in 2018.   That means the 142 remaining credit unions lost $718 million for a loss rate of only .65 of 1 basis point.

In the context of a $20 billion insured fund with total capital equal to 1.3% of insured savings, the fund is 200 times larger than the insured losses if the disruptive event of the taxi medallions is not included.  If counted, the fund as noted, is 93 times larger than the eleven-year  insured loss rate.

Reasons for Failures

Figure 7 on page 19 is a table labelled: Top Material Loss Review Causes or Contributors to Failure by Number of Times Mentioned.

This is the list of the six causes from most to less frequently cited:

  1. Credit Union Board or Committee Oversight
  2. Failure by NCUA examiners
  3. Weak or missing NCUA Guidance
  4. Fraud
  5. Management integrity
  6. Lack of timely and aggressive NCUA action

All of these six areas are why there is an examination of every insured credit union.  These “causes of failure” should be covered in every exam.

The report does not cite economic circumstances or external disruptive events, as in the taxi medallion credit unions, as reasons for losses.  The report began after the Great Recession with losses in 2010 when the economic recovery was well underway.

What the report makes clear is that NCUA’s exam program has much room for improvement.

At yesterday’s November board meeting, the CFO commented that the positive NCUSIF AME recoveries from prior loss estimates has continued into November.   So the net loss reserving expense for 2021 is, in effect, negative.   This means the two most recent NCUSIF loss ratios cited above should be even lower when this year’s results are added to this study’s total.

 

 

 

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Leading with Competence, Not Position or Authority

On January 7, 1984, NCUA Chairman Ed Callahan spoke to the Hawaii Credit Union League’s Political Action Conference.  This was the predecessor to today’s governmental affairs conference.

He opened by discussing deregulation a term he described as “overused and misunderstood.”  “I was not the inventor, but I gave it a good push.”

He then addressed why credit unions had been so uneasy, even fearful with this radical change that would apply to entire financial industry.  The fear was whether cooperatives could compete.  For on December 14, 1982, in a first step, all rates for all institution’s  money market accounts were removed.

He then presented the evidence. Growth in savings showed credit unions, whose liabilities (shares) had been totally deregulated in May 1982, had increased by double digits for three consecutive years, far ahead of the banking industry’s outcome.

The most important benefit of the change was that credit unions would make their own business decisions not government bureaucrats.  There was no more “follow the leader” putting all our “eggs in one basket.”  He also recognized “some will succeed more than others.”

The Rest of the Story

He then explained the additional changes necessary for this result to succeed.

The agency had approved a “more realistic common bond” which he believed would have the most lasting “real impact in the long run.”

He talked about the agency’s decentralization, putting resources into the field where they were most needed in order to conduct an annual exam program.   “We threw out the old cookbook and created a new exam process so we could be “problem solvers” if required.”

The agency needed to be “more efficient” using the resources provided by credit unions.  One example was “resource sharing” where the agency would compensate credit unions who would lend their personnel and knowhow to assist other credit unions experiencing difficulties.

Finishing the Job

He closed asking support for a new design for the NCUSIF.  The Fund was “not competitive” relying on double premiums to try to meet the 1% of shares objective set in the Act.

The new design would be “less costly, puts control of funds in your hands, and makes the fund all yours when you put up the money.”  This change would “complete the system.”

Leadership Change that Lasts

Ed took questions at the end of the talk replying to attendees’ concerns about “overlapping FOM’s, competition for members,” and the threat of taxation.

He closed with the thought that he did not want to be remembered for what he had done as NCUA chair but rather for “being part of the future.”

His ending rouser challenged credit unions: “You’ve been a model for your members; now become an even better one.”

What Sets a Leader Apart-“Feeling Safe”

Ed did not lead change by preaching fear.  Instead in this speech and many others he directly addressed the “fears” that credit union leaders shared.   Fear of the unknown future, competition from without and within the industry, or the lack of expertise and navigating an economic recovery with members.

Hearing him speak, credit unions “felt safe” with his proposals for the future.   They had confidence not just in current results, but in the way the agency presented the context for change-the transparency, the joint efforts, and the shared belief in the unique value of the cooperative system.

In 1984 credit unions supported Congress’ change of the NCUSIF to a 1% deposit-based system, bringing all the benefits described in the plan.   This was critical for credit unions to have a sound, unique and competitive future in the newly deregulated financial markets.

Ultimately the trust in any organization depends on those who interact with it, “feeling safe” with its leaders.   That belief is real; it is earned not granted by position; and it is the fundamental confidence required for any system’s success.

One of Ed’s gifts was instilling confidence in others and their ability to succeed.  Every coach knows this reality if there is to be a winning team.  An example that is  much needed today in DC.

 

 

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When Words Matter Most

On November 5th, Pomona Postal FCU, founded in 1964, became NCUA’s  fifth conservatorship of 2021.

The Credit Union Times story contained this standard explanation:

The NCUA issued a media release and other information, showing the agency took possession and control of the insured credit union to conserve its assets, protect the National Credit Union Share Insurance Fund, and resolve operational problems that could affect the credit union’s safety and soundness.

At September 30,  this $4.2 million credit union reported a net worth of 6.86%–down .01bps from a year earlier; an ROA of .48, delinquency of $33,184 covered by an allowance of $41,000.

The Critical Question

This action raises again the ultimate question, Why?  The $20 billion NCUSIF had to be “protected” from the deprecations of this $4.4 million monster disguised in tiny sheep’s clothing?

Or, as typical of other small credit union seizures, will we learn from court records (years from now) that there has been a long, on-going pattern of misdeeds in this two-employee firm, overlooked in multiple past annual NCUA exams?

Or, perhaps it is just examiner and regional office frustration that their supervision has been unable to stabilize a slowly declining financial picture?

Both options are troubling. The failure of NCUA to be transparent in the use of its most absolute authority is itself a symptom of the real issue.

If NCUA is unable to supervise this credit union speck in the $2.2 trillion system, how can anyone have confidence in their oversight of a $40 or $400 million, let alone a $4.0 billion entity.

The irony of NCUA’s explanation is stunning.  For if true that this $4.4 million was taken over to protect the insurance fund, the greatest danger to the system is not from credit union malfeasance or failures; rather it is NCUA’s incompetence.

It is time for the agency to drop the bureaucratic doublespeak and start giving straight talk about its actions. For the issue is not what happened at Pomona Postal but why the agency feels so compelled to cover up its most important responsibility.

 

 

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Two CEO’s Experiences with  NCUA

From a retired 30-year CEO commenting on NCUA’s oversight of loans to credit union executives and directors- (2021).

“I hope NCUA has improved their guidance for loans to Management and the Board of Directors.  We merged with a credit union that had a policy that Board members, management and their families could borrow $100,000 each unsecured.  When we merged with them we found the Manager, his wife and two sons each borrowed $100,000 as well as the Asst Manager and two directors.

Each went bankrupt and the loans were never paid. When I challenged NCUA, CUMIS and our lawyers, they all said since they went bankrupt, we could not collect from them as long as the Board approved the policy allowing them to borrow up to $100,000 each unsecured.  NCUA should have a policy that officials cannot have special terms that the members do not have. “

Changing Role of the Regulator: A  Relationship That Should Be Based on Mutual Respect (1984)

“. . . it seemed as though we would never escape the attitude that the regulator knows best. . . A dramatic change has taken place in the last few years.  We now have a federal regulatory agency which openly concedes that credit union people know more about running credit unions than the agency does. . .

The relationship between credit unions and the regulatory agency is one founded on mutual self-respect, and on the realization that both sides share equally in the responsibility for the survival and future development of credit unions. . .

The nature of the federal bureaucracy being what it is. . .there will be a great amount of inertia to cause it to revert a less creative and less cooperative approach to regulating credit unions. 

I would not like to see that happen.”

Frank Wielga, CEO Pennsylvania State Employees credit Union. Source: NCUA 1984 Annual Report